Fund Manager: Dollar Tree Can Gain More Than 50%

By

Eric Clark, Accuvest Global Advisors

Jan. 24, 2019 5:20 p.m. ET

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This article first appeared on SumZero, the world’s largest research community of buyside investment professionals. In some cases Barron’s edits the research for brevity; professional investors can access the full version of this thesis and tens of thousands of others at SumZero.com.

Disclaimer: The author and his fund had a position in this security at the time of posting and may trade in and out of this position without informing the SumZero community.

Target price: $150.00

Recent price: $94.44

Timeframe: 1-2 years

Inflation is always present in the system regardless of what government statistics say. Companies have to account for this via the pricing of their products and services. This is nowhere more apparent than in the dollar-store concept. There’s an enormous investment opportunity currently in dollar-focused retailers that understand the need to “break from the buck,” expanding their product offerings and going beyond the $1 price point. The dollar concept is appreciated by consumers, but in my experience it’s more of a concept than a demand. That gives stores like
Dollar Tree,
Family Dollar and even
Dollar General
room to expand up in price as Five Below has done very successfully. That means enormous sales and margin expansion, with efficiencies that current estimates do not reflect.

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Dollar Tree is my favorite way to play this theme, and it is becoming an activist’s favorite (Starboard, Jana Partners, Corvex Management) as well. Thus far, management has been stubborn to untether from the $1 price point, but they have gotten the message, made a key strategic hire and are listening and open to positive change. There’s a lot of moving parts to the Dollar Tree story, but any positive movements toward a rebranding away from the $1 price point and a restructuring or spinoff of the Family Dollar stores that are currently acting as an anchor to the overall business should reward shareholders.

There’s enormous upside to the DLTR story. As with all risk-taking, nothing is a guarantee. Management could dig in and do nothing about Family Dollar and the tethering to the $1 price point. This unique investment opportunity has an asymmetric risk/reward skewed in a long’s favor until I see data that supports otherwise.

DLTR thesis

A Fortune 200 company that operates more than 15,000 stores across 48 states and five Canadian provinces as of Nov. 3, 2018, Dollar Tree is composed of these brands: Dollar Tree, Family Dollar, Dollar Tree Canada. The dollar concept is one that’s vital to a large segment of the U.S. economy. Collectively, the stores touch a majority of Americans across all major metropolitan areas, regardless of socioeconomic status. Consumers of all income levels love a good treasure hunt and an even better bargain. When the economy is strong, consumers trade up and pay up but still seek bargains. As the economic cycle peaks, consumers begin to trade down. The dollar stores benefit greatly at the end of the cycle, and the stocks have historically been quite defensive in difficult stock market periods as money flows to defensive slowdown beneficiaries. My 8-year-old daughter loves her trips to Dollar Tree for a fun treasure hunt!

What needs fixing: the price focus and Family Dollar Stores.

In the summer of 2014, Dollar Tree announced it would buy competitor Family Dollar for roughly $9.5 billion and assume $1 billion of FDO’s debt. Dollar Tree beat a rival bid from Dollar General. The FDO deal effectively doubled DLTR’s footprint by acquiring a roughly 8200-store chain that caters to low-income shoppers. In hindsight, acquiring Family Dollar was a flawed decision as it competed directly with well-funded retailers like
Walmart.
The brand power, inventory management and ruthless price focus of Walmart is always tough to compete with. The low-price focus though, gave Dollar Tree and Dollar General an advantage over their large rivals. Unfortunately, Family Dollar stores have a reputation for being run-down and not having enough relevant products for the demographic they serve. This is largely due to lack of updated inventory control and common-sense product placements at the store level. Store managers should have control of the inventory decisions based on their understanding of the local markets. As core Dollar Tree stores continue to perform well and FDO stores lag badly, management will have no choice but to make smart-decisions as FDO sales account for roughly half of total revenue. The arrival of activists will only push management to the decisions they are already considering. This is the catalyst that drives this recommendation.

The opportunity:

1. Dollar Tree: Stores are generally well positioned geographically, and management has unveiled a cap-ex facelift in an attempt to gain consumer traffic.

2. Family Dollar: This is a brand that’s tarnished, in need of a major facelift, or a new owner that is willing to make tough decisions. Margins are depressed but could revert to the mean if there were strategy upgrades, logistics and systems upgrades, and empowered store managers. If DLTR management goes to sleep and does nothing, the stock will go lower, and my thesis will be wrong. Given how obvious the problem is and how persistent the activists will be, I find this thesis to be the least likely outcome. Nonetheless, there’s likely 20% downside to the stock if management keeps their heads in the sand. If management gets pushed to sell FDO and has no interest in dealing with the No. 3 opportunity, the stock is probably fully priced and less interesting as an investment.

3. Rebranding and untethering from the $1 price point. Combining a plan for No. 2 and untethering from the $1 price point is the home run I believe is most likely. There’s enormous financial leverage in management’s decision to rationalize the FDO stores and expand their reach toward $5-$10 price points. This decision is logical and expands management’s ability to add significant new consumption categories. That will drive significantly higher sales and margins. It’s under this scenario that I believe the stock can double in two to three years. An announcement by management that this is the focus should be worth a 10% bump immediately.

The initial signs are positive:

1. Activists are engaged, and DLTR management has stated publicly they welcome the opportunity to hear positive plans for the company. Sometimes, just a public open outcry is all it takes to get boards and management teams engaged in positive change. The fact that the current management team has allowed FDO to erode the way it has puts the team under a microscope. Microscopes tend to get people motivated.

2. New board member: Tad Dickson has a storied history of turnarounds and sales. On Jan. 1, 2019, Tad joined the DLTR board. Tad has a history of working well with Jana Partners and has a number of sales and turnarounds on his résumé (Harris Teeter, CST Brands, Whole Foods). Adding a guy like Tad with this kind of résumé speaks volumes regarding management’s willingness to consider options for Family Dollar, the price points and even a full sale of Dollar Tree.

Dollar Tree’s inventory has changed over the years, as it should. What I find interesting is the stubborn focus on the $1 price point has not changed since the first store opened in the mid-1980s. It’s time for a badly needed upgrade of the price points. To reiterate, this thesis is too logical to ignore, and with activists pushing firmly, management is likely to make meaningful shifts in the right direction. Their interest in buying Family Dollar, which has wider price points, stands firmly in contrast with management’s decision to stay stubborn on the $1 focus at Dollar Tree.

Breaking away from the buck has enormous margin expansion opportunities. Here’s the domino effect as I see it: Dollar Tree is limited to a “margin single-lane road.” Expanding to a freeway is accomplish this way: Expanding the price range

leads to an expansion of product categories, which expands sales and margins and ultimately, the stock price. Add to that the possible sale or upgrading of Family Dollar Stores and you have a large opportunity for longs via a stronger, more

diverse Dollar Tree or whatever the updated brand name becomes. My vote is for DollarPLUS.

Normally the brands I invest in have strong economic moats with high pricing power. In retail, however, a quant would firmly show that some of the best investment returns come from companies with high sales volume and low prices and margins. Counterintuitive yes, but consumers keep coming back when you offer them an acceptable experience, with products they want/need and at prices that keep them loyal. The data is clear on popular retailers focused on lower prices and high volume. There’s been some significant long-term winners such as Costco, Walmart, TJ Maxx,
Ross Stores,
etc. In fact, Dollar Tree stock has gained over 900% over the last 20 years versus the S&P 500’s roughly 200% gain.

For the full report, including tariff risks and details on fixing Family Dollar, go to SumZero.com.

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